Midyear Report: Why investors turn to rail

Union Pacific’s record $3.7 billion in capital expenditures in 2012 returned quick dividends, and resulted in the 151-year-old railroad’s best year for its investors.

In the company’s 2012 annual report, President and CEO Jack Koraleski said Union Pacific continues to make capital investments that “play a critical role in meeting the long-term demand for freight transportation in the U.S. In 2012, we invested a record $3.7 billion across our network, supported by our best-ever financial returns. Over half was spent on replacing and hardening our infrastructure to further enhance safety and reliability. The balance was invested to increase customer value, support business growth, and advance efforts on PTC implementation. Through 2012, we have invested nearly $750 million of our estimated $2 billion spend on PTC.

“A significant portion of our growth capital investment in 2012 was targeted to the southern region of our network to meet growing demand for new business, particularly in the shale-related energy arena. The increasing development of oil production in various domestic shale formations is providing an emerging market opportunity for rail with shipments of inbound frac sand and pipe, and outbound crude oil. In 2012, the impact was substantial: Our crude oil shipments grew more than threefold compared to 2011. Going forward, we anticipate continued opportunities for growth in this market driven by our proven ability to provide an efficient and flexible transportation solution for growing demand.

“In an evolving marketplace, our franchise diversity remains an absolute core strength of Union Pacific. An increasing U.S. population base will stimulate long-term growth for many of the goods we carry. To meet this growing demand, we anticipate continued opportunities to convert freight from the highway, supported by our integrated network, competitive service offerings, and environmental advantages. We also play a vital role in the global supply chain, with international trade currently representing more than 30% of our revenue base. In particular, as the only railroad to serve all six major gateways to Mexico, we are in an excellent position to benefit from economic growth there.”

At CSX, expansion in domestic and international intermodal markets “will help drive continued long-term profitable growth,” Chief Financial Officer Fredrik Eliasson told analysts at the 2013 Cowen and Company 6th Annual Global Transportation Conference in New York. “Our network serves nearly two-thirds of the nation’s population and is well-positioned to capture a significant share of the domestic intermodal market opportunity, estimated at about 9 million total loads in the eastern U.S. “nvestments in expanded capacity will help convert this long-run opportunity, building on about 30% growth in our intermodal business over the past three years.”

CSX shipped 2.5 million intermodal containers in 2012, with 90% of that traffic in doublestack service. The company continues to invest in capital projects to expand its intermodal network, which will further increase doublestack corridors by 2015, with hubs aligned with major ports and population centers.

Investment strategies like these, and the returns on those investments, continue to inspire confidence on Wall Street. “Investors are driving railroad stocks to their best start to a year since 2008, looking past downgrades by Wall Street analysts, in a bet that Warren Buffett is right about the carriers’ long-term prospects,” Bloomberg News recently observed. “A 23% surge for the S&P 500 Railroads Index in 2013 is outpacing the S&P 500’s 14% jump. Crude oil, a homebuilding rebound, and the fastest auto sales pace in six years are buoying earnings, and options-market trading data analyzed by Bloomberg show investors expect the rally to continue. The Rail Index’s return has almost doubled the S&P 500’s advance since Buffett’s Berkshire Hathaway bought BNSF in 2009.”

Said one analyst, “If you believe the U.S. economy is on a path, no matter how slow, to recovery, then the railroads will benefit from it—probably more than most. For some of these stocks, the valuations are quite high relative to their history, but they’re not so inflated that it’s crazy.” Said another analyst, “The floor isn’t going to fall out from underneath the big-picture story for the railroads. It’s really incredible with the rails how, over the past 10 years, whenever one part of their business goes into a decline, something else comes to the fore as a growth area.”

“We remain positive on the railroad group for investors as we head into the back half of the year,” says Cowen & Co. Managing Director and Railway Age Contributing Editor Jason Seidl. “There has been a tremendous amount of interest in the group in the first half, and given our outlook for the second half, we believe the sector should do well.”

THE CRUDE OIL BOOM

Crude by rail (CBR) has become a bright spot for the industry. Along with intermodal, it has helped to offset declines in coal. Despite some narrowing in the price differential between CBR and pipelines, the sector is still expected to grow significantly.

“Narrowing differentials pressure the economics of CBR in certain geographies and will likely slow its growth, but we don’t foresee a collapse in CBR,” says Morgan Stanley’s William Greene. “With production still rising, rail is needed to clear supply and deliver to refineries lacking pipeline access to new production areas. Shrinking differentials are a headwind to CBR volumes in the near-term, but volumes won’t collapse to zero. Investors have become increasingly concerned about the sustainability of CBR volumes, as crude oil differentials have compressed to their lowest levels in 18 months. Bears argue that differentials are now too low to justify the economics of crude-by-rail, and if they remain this low, shippers will increasingly shift to less expensive alternatives such as pipelines or foreign crude imports.

“In our view, shrinking differentials do pose a risk to CBR in the near term, but we believe that (1) sunk costs and locked-in deals with rail at some refiners reduces the cash break-even for rail movements; (2) with North American production still rising, rail will be needed to clear supply and deliver to East/West Coast refineries that lack pipeline access to new producing regions; and (3) rail will remain a part of the long-term infrastructure solution for transporting crude. Weaker CBR volumes will have a limited financial impact on Class I’s. While the growth in CBR volumes across Class I’s has been nothing short of astounding over the past 18 months, we remind investors that crude oil still accounts for a very small portion of Class I volumes, and therefore earnings. In 2012, petroleum products accounted for less than 2% of total Class I volumes, and crude oil specifically accounted for less than a third of all petroleum products. Thus, consistent with our belief that investors should be careful not to overestimate the near-term upside to earnings from CBR, we also believe the risk to Class I earnings from a near-term pullback in CBR volumes will be relatively limited.

“It’s not just about the differentials. While differentials certainly play a role in the economics of choosing to haul crude-by-rail, there are numerous advantages crude-by-rail offers vs. pipelines including efficiency, geographic optionality, shorter contract terms, and product purity, just to name a few. CBR is not a temporary phenomenon, in our view, and we continue to expect rail to be part of the long-term infrastructure solution for moving crude for many domestic regions.”

“We’ve never seen a business that has grown so fast,” BNSF chief executive Matt Rose told Railway Age in a recent conversation. “CBR is backfilling 50% of our coal loss, and we are allocating a significant amount of capital to our Northern Corridor for CBR. We know we can get our investment back. Right now, we’re moving 650,000 bbl. per day—10% of all the oil consumed in the U.S.—and we expect to grow to 750,000 to 800,000 bbl. by year’s end.”

Last year, BNSF spent $3.9 billion and this year bumped its capex number up to $4.1 billion, a record. “We will continue investing capital to make our network stronger,” said Rose. “That way, more customers will want to use us. A more-efficient network creates commerce, which in turn creates jobs. That’s our story.”

Looking toward the second half

By Jason Seidl, Contributing Editor

Rail stocks have run up more than 20% this year, with many carriers’ shares hitting all-time highs. Shares reached these lofty levels with a backdrop of economic sluggishness and continued pressure on key commodities such as coal and agricultural products. Railroad earnings reported for first-quarter 2013 were a mixed bag in our view, but investors flocked to the rail space as many wanted exposure to economically sensitive early-cycle stocks. For this momentum to continue, investors may want more in terms of underlying earnings performance than what was produced in the first quarter. We believe this is possible in the second half of the year, given easing year-over-year comparisons, an expected tightening of capacity in the truckload (TL) space, growth in crude-by-rail movements, and pricing gains that are above rail cost inflation (other than export coal).

Indeed, comparisons are easing in carloadings in the back half of this year for both coal and agricultural products. Coal carloadings were down roughly 10% in second-half 2012, with the fourth quarter taking the brunt of the declines. Unusual weather in the spring should lead to coal stockpiles coming down in many parts of the country, which bodes well for the outlook for the latter part of the year. Investors may recall that agricultural traffic took a dip in the fourth quarter as a 50-year drought ravaged crops across many of the key production areas in the U.S. A recent World Agricultural Supply and Demand Estimates report was slightly more bearish for corn, with wetter weather delaying plantings somewhat. That being said, this year’s corn crop is still slated to be nearly 30% higher than last year, at a record 14 billion bushels. Wheat and soybeans are also expected to be higher, and that should be positive for rail carloadings in the fourth quarter.

The rail industry has become even more competitive vs. the trucking industry during the past decade, as intermodal service reliability has greatly improved, energy prices have risen, and rail carriers have opened up numerous origin/destination pairs. Instead of looking only at lanes over 1,000 miles, the rails are targeting lanes as short as half of that distance. Now, trucking carriers have new hours of service regulations staring them in the face, which could take utilization rates for over-the-road carriers down by as much as 6%. Most carriers have not been growing their fleets in 2013, and if demand starts to pick up, that could mean a shortage of trucks available for the shipping community. This should lead to a rise in TL spot rates and an eventual rise in TL contract rates. Since TL rates act as a ceiling for intermodal prices, we believe intermodal carriers will have the opportunity to take both market share and some rate increases in the back half of the year. Unlike the TL carriers, intermodal players should not be plagued with as much of a rise in expenses associated with aforementioned utilization degradation.

While we expect continued solid growth in intermodal business, the crude-by-rail business should continue to soar. Indeed with many carriers posting growth ranging from strong double-digit gains to up nearly 400%, the crude-by-rail business has captured the attention of many investors. Crude shipments were just 0.8% of total traffic in 2012, but should be closer to 2% as we exit 2013. Earlier this year we issued a collaborative report entitled “Crude Logistics: Early Innings and Here to Stay,” and our views remain intact on the upside for the rail industry. Recent conversations we have had with industry professionals have cemented our view that rails should have a place at the table, even if pipelines expand. Producers like many things about rail, including the flexibility that the rail network provides them, faster speed to market (rail can be five times faster than pipeline movements), shorter rail contract terms, and other factors. We do not believe rails will take the place of pipelines. Rather, we see the crude supply chain existing for many years with a dual option format. One just has to look at the billions of dollars that have been invested in crude oil facilities and associated tank cars by energy producers and marketing companies.

Railway Age Contributing Editor Jason Seidl is a Managing Director at Cowen and Company.